I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets. I will freely admit that this has led me to make a number of investment mistakes, although these have generally been sins of omission rather than actual investment losses. The Italian political situation and the sharp rise in Italian bond yields it precipitated, last week, is, therefore, some justification for an investor like myself, one who has not held any fixed income securities since 2010.

Italy had been without a government since its March 4 election, which yielded a hung parliament with no party or coalition holding a majority. The Five Star Movement and Lega Nord finally reached a deal, to most everyone’s surprise since those two parties, while both broadly populist, have some big differences. Nonetheless, they found enough common ground to propose a cabinet to President Sergio Mattarella.

Italian presidents are generally seen as rubberstamp figureheads. They really aren’t supposed to insert themselves into the process. Yet Mattarella unexpectedly rejected the coalition’s proposed finance minister, 81-year-old economist Paolo Savona, on the grounds Savona had previously opposed Italy’s eurozone membership. This enraged Five Star and Lega Nord, who then ended their plans to form a government and threatened to impeach Mattarella.

The whole article is well worth reading and goes on to look at debt from a global perspective. John anticipates what he calls, ‘The Great Reset,’ when the reckoning for the excessive levels of debt arrives.

Returning to the repricing of Eurozone (EZ) debt last month, those readers who have followed my market commentaries since the 1990’s, might recall an article I penned about the convergence of European government bond yields in the period preceding the introduction of the Euro. At that juncture (1998) excepting Greece, every bond market, whose government was about to adopt the Euro, was trading at a narrower credit spread to 10yr German bunds than the yield differential between the highest and lowest credit in the US municipal bond market. The widest differential in the muni-market at that time was 110bp. It was between Alabama and California – remember this was prior to the bursting of the Tech bubble.

In my article I warned about the risk of a significant repricing of European credit spreads once the honeymoon period of the single currency had ended. I had to wait more than a decade, but in 2010/2011 it looked as if I might be vindicated – this column is not entitled In the Long Run without just cause – then what one might dub the Madness of Crowds of Central Bankers intervened, saved the EZ and consigned my cautionary oracles, on the perils of the quest for yield, to the dustbin of history.

In the intervening period, since 2011, I have watched European yields inexorably converge and absolute yields turn negative, in several EZ countries, with a temerity which smacks of permanence. I have also arrived at a new conclusion about the limits of credit risk within a currency union: that they are governed by fiat in much the same manner as currencies. As long as the market believes that Mr Draghi will do, ‘…whatever it takes,’ investors will be enticed by relatively small yield enhancements.

Let me elaborate on this newly-minted theory by way of an example. Back in March 2012, Greek 10yr yields reached 41.77% at that moment German 10yr yields were a mere 2.08%. The risk of contagion was steadily growing, as other peripheral EZ bond markets declined. Greece, in and of itself, was and remains, a small percentage of EZ GDP, but, as Portuguese and Spanish bonds began to follow the lead of Greece, the fear at the ECB – and even at the Bundesbank – was that Italy might succumb to contagion. Due to its size, the Italian bond market, was then, and remains today, the elephant in the room.

During the course of last month, European bond markets diverged. The table below shows the change in 10yr yields between 1st and 31st May:-

Source: Investing.com

A certain degree of contagion is evident, although the PIGS have lost an ‘I’ as Irish Gilts have escaped the pejorative acronym.

At the peaks of the previous crisis, Irish 10yr Gilts made a yield high of 14.61% in July 2011, at which point their spread versus 10yr Bunds was 11.34%. When Italy entered her own period of distress, in November of that year, the highest 10yr BTP yield recorded was 7.51% and the spread over Germany reached 5.13%. By the time Greek 10yr yields reached their zenith, in March 2012, German yields were already lower and Irish and Italian spreads had begun to narrow.

During the course of last month the interest rate differential between 10yr Bunds and their Irish, Greek and Italian counterparts widened by 41, 100 and 114bp respectively. Italian 10yr yields closed at 4.25% over Bunds, less than 100bp from their 2011 crisis highs. With absolute yields significantly lower today (German 10yr yields were 2.38% in November 2011 they ended May 2018 at 36bp) the absolute percentage return differential is even higher than during the 2011 period. At 2.72% BTPs offer a return which is 7.5 times greater than 10yr Bunds. Back in 2011 the 7.51% yield was a little over three times the return available from 10yr Bunds.

I am forced to believe the reaction of the BTP market has been excessive and that spreads will narrow during the next few months. If I am incorrect in my expectation, it will fall to Mr Draghi to intervene. The Outright Monetary Transactions – OMT – policy of the ECB allows it to purchase a basket of European government bonds on a GDP weighted basis. If another crisis appears immanent they could adjust this policy to duration weight their purchases. It would then permit them to buy a larger proportion of the higher yielding, higher coupon bonds of the southern periphery. There would, no doubt, be complaints from those countries that practice greater fiscal rectitude, but the policy shift could be justified on investment grounds. If the default risk of all members of the EZ is equal due to the political will of the European Commission, then it makes sense from an investment perspective for the ECB to purchase higher yielding bonds if they have the same credit risk. A new incarnation of the Draghi Put could be implemented without too many objections from Frankfurt.

Conclusions and investment opportunities

I doubt we will see a repeat of the 2011/2012 period. Lightening seldom strikes twice in the same way. The ECB will continue with its QE programme and this will ensure that EZ government bond yields remain at artificially low levels for the foreseeable future.

Unusually, I have an actionable trade idea: caveat emptor! I believe the recent widening of the 10yr Italian BTP/Spanish Bonos spread has been excessive. If there is bond market contagion, as a result of the political situation in Italy, Bonos yields may have difficulty defying gravity. If the Italian political environment should improve, the over-sold BTP market should rebound. If the ECB are forced to act to avert a new EZ crisis by increasing OMT or implementing a duration weighted approach to QE, Italy should benefit more than Spain until the yield differential narrows.

US bond yields have risen from historic lows, they should rise further, they may not

The Federal Reserve is beginning to reduce its balance sheet other CBs continue QE

US bonds may still be a safe haven but a hawkish Fed makes short duration vulnerable

Short dated UK Gilts make be a safe place to hide, come the correction in stocks

US Bonds

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody – James Carville 1993

Back in the May 1981 US official interest rates hit 20% for the third time in 14 months, the yield on US 10yr Treasury Bond yields lagged somewhat and only reached their zenith in September of that year, at 15.82%. In those days the 30yr Bond was the global bellwether for fixed income securities; its yield high was only 15.20%, the US yield curve was inverted and America languished in the depths of a deep recession.

More than a decade later in 1993 James Carville, then advisor to President Bill Clinton, was still in awe of the power of the bond market. But is that still the case today? Back then, inflation was the genie which had escaped from the bottle with the demise of the Bretton Woods agreement. Meanwhile, Paul Volker, then Chairman of the Federal Reserve was putting into practice what William McChesney Martin, one of his predecessors, had only talked about, namely taking away the punch bowl. Here, for those who are unfamiliar with the speech, is an extract; it was delivered, by Martin, to the New York Bankers Association on 19th October 1955:-

If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. … In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects–if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.

Back in the October 1955 the Discount rate was 2.30% and the 10yr yield was 2.88%. The economy had just emerged from a recession and would not embark on its next downturn until mid-1957.

Today the US yield curve is also unusually flat, especially by comparison with the inflationary era of the 1970’s, 1980’s and 1990’s. In some ways, however, (barring the inflationary blip in 1951-52) it looks similar to the 1950’s. Here is a chart showing the 10yr yield (blue – LHS) and US inflation (dotted – RHS):-

Source: Trading Economics

I believe that in order to protect the asset markets (by which I mean, principally, stocks and real estate) the Federal Reserve (charged as it is with the twin, but not mutually exclusive, objectives of full-employment and stable prices) may decide to focus on economic growth and domestic harmony at the expense of a modicum of, above target, inflation. When Fed Chairman, Martin, talked of removing the punch bowl back in 1955, inflation had already subsided from nearly 10% – mild deflation was actually working its way through the US economy.

Central Bank balance sheets

Today there are several profound differences with the 1950’s, not least, the percentage of the US bond market which is held by Central Banks. As the chart below shows, Central Banks balance sheet expansion continues, at least, at the global level: it now stands at $14.6trn:-

Source: Haver Analytics, Yardeni Research

Like the Fed, the BoJ and ECB have been purchasing their own obligations, by contrast the PBoC’s modus operandi is rather different. The largest holders of US public debt (principally T-Bonds and T-Bills) are foreign institutions. Here is the breakdown as at the end of 2016:-

Source: US Treasury

As of November 2017 China has the largest holding of US debt – US$1.2trn (a combination of the PBoC and state owned enterprises), followed by Japan -US$1.1trn, made up of both private and public pension fund investments. It is not in the interests of China or Japan to allow a collapse in the US bond market, nor is it in the interests of the US government; their ability borrow at historically low yields during the last few years has not encouraged the national debt to decline, nor the budget to balance.

Bond Markets in Europe and Japan

The BoJ continues its policy of yield curve control – targeting a 10bp yield on 10yr JGBs. Its balance sheet now stands at US$4.8trn, slightly behind the ECB and PBoC which are vying for supremacy mustering US$5.5trn apiece. Thanks to the persistence of the BoJ, JGB yields have remained between zero and 10bp since November 2016. As of December 2017 the BoJ owned 46.2% of the total issuance. The ECB, by contrast, holds a mere 19.2% of Eurozone debt.

Another feature of the Eurozone bond market, during the last couple of years, has been the continued convergence in yields between the core and periphery. The chart below shows the evolution of the yield of 10yr Greek Government Bonds (LHS) and German Bunds (RHS). The spread is now at almost its lowest level ever. This may be a reflection of the improved performance of the Greek economy but it is more likely to be driven by fixed income investors continued quest for yield:-

Source: Trading Economics

By contrast with Greece (where yields have fallen) and Germany (where they are on the rise) 10yr Italian BTPs and Spanish Bonos have remained broadly unchanged, whilst French OATs have seen yields rise in sympathy with Germany. Hopes of a Eurobond backed by the EU, to replace the obligations of peripheral nation states, whilst vehemently denied in official circles, appears to remain high.

Japanese and European economic growth, which has surprised on the upside over the past year, needs to prove itself more than purely cyclical. Both regions are reliant on the relative strength of US the economic recovery, together with the continued structural expansion of China and India. The jury is out on whether either Japan or the EU can achieve economic terminal velocity without strong export markets for their goods and services.

The one country in the European area which is behaving differently is the UK; yields have risen but, it stands apart from the rest of the Eurozone; UK Gilts dance to a different tune. Uncertainty about Brexit caused Sterling to decline, especially against the Euro, import prices rose in response, pushing inflation higher. 10yr Gilt yields bottomed in August 2016 at 50bp. Since then they have risen to 1.64% – this is still some distance from the highs of January 2014 when they tested 3.09%. 2yr Gilts are different matter, with a current yield of 71bp they are 63bp from their lows but just 22bp away from the 2014 high of 93bp.

Conclusions and Investment Opportunities

From a personal investment perspective, I have been out of the bond markets since 2013. My reasoning (which proved expensive) was that the real-yields on the majority of markets was already extremely negative and the notional yields were uncomfortably close to zero. Of course these markets went much, much further than I had anticipated. Now I am tempted by the idea of reallocating, despite yields being lower than they were when I exited previously. Inflation in the US is 2.1%, in the Euro Area it is 1.3% whilst in Japan it is still just 1%.

In Japan yields are still too near the zero bound to be enticing. In Germany you need to need to go all the way out to 6yr maturity Bunds before you receive a positive yield. There is an alternative to consider – 2yr Gilts:-

Source: Trading Economics

UK inflation is running at 3% – that puts it well above the BoE target of 2%. Rate increases are anticipated. 2yr Gilt yields have recently followed the course steered by the US and Germany, taking out the highs last seen in December 2015, however, if (although I really mean when) a substantial stock market correction occurs, 2yr Gilt yields have the attraction of being near the top of their five year range – unlike 2yr Schatz which are nearer the bottom of theirs. 2yr Gilts will benefit from a slowdown in Europe and any uncertainty surrounding Brexit. The BoE will be caught between the need to quell inflation and the needs of the economy as a whole. 2yr Gilts also offer the best roll-down on the UK yield curve. The 1yr maturity yields 49bp, whilst the 3yr yields 83bp.

With inflation fears are on the rise, especially in the US and UK, 2yr Gilts make for an uncomfortable investment today, however, they are a serious contender as a safe place to hide, come the real stock market correction.

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016.

Was I simply wrong or just horribly premature, only time will tell? The December end of the asset purchase programme is growing inexorably closer. So far, however, despite a rise in the popularity of AfD in Germany, the Eurozone seems to have maintained its equanimity. The Euro has not weakened but strengthened, European growth has improved (to +2.3% in Q2) and European stock markets have risen. But, perhaps, the most interesting development has occurred in European bond markets. Even as the Federal Reserve has raised short term interest rates, announcing the beginning of balance sheet reduction, and the ECB has continued to prepare the markets for an end to QE, peripheral bonds in Europe have seen a substantial decline in yields: and their respective spreads against the core German Bund have narrowed even further. Is this a sign of a more cohesive Europe and can the trend continue?

To begin here is a chart of the Greek 10yr and the German 10yr since January, the Bund yield is on the Left Hand Scale and the Greek 10yr Bond on the Right:-

Source: Trading Economics

The table below looks at a selection of peripheral European markets together with the major international bond markets. Switzerland, which has the lowest 10yr yield of all, has been included for good measure. The table is arranged by change in yield:-

Source: Investing.com

This year’s clear winners are Greece and Portugal – the latter was upgraded to ‘investment grade’ by S&P in September. It is interesting to note that despite its low absolute yield Irish Gilts have continued to converge towards Bunds, whilst BTPs and Bonos, which yield considerably more, have been tentatively unnerved by the prospect of an end to ECB largesse.

As an aside, the reluctance of the Bonos to narrow versus BTPs (it closed to 41bp on 4th October) even in the face of calls for Catalonian independence, appears to indicate a united Spain for some while yet. Don’t shoot the messenger I’m only telling you what the markets are saying; in matters of politics they can be as wrong as anyone.

One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader. While this is certainly noteworthy, to say the least, the direct political implications are likely to be minimal. None of the other parties is going to form a coalition with them and AfD members of parliament are likely to be treated as political pariahs. We have seen this happening in German state parliaments many times before.

However, I think there might be two important indirect consequences of the AfD’s electoral success. First, within Germany the pressure on Merkel, not least from her own party, with regards to policy changes is going to build up. For obvious reasons, preventing the rise of a right-wing nationalist movement has been a central dogma in German politics. That’s out of the window now after the AfD’s double digits score last night – on Merkel’s watch. In the past, she has been willing to revise long-held positions (on nuclear power, the minimum wage, same sex marriage etc.) when she felt that sentiment amongst voters was shifting. In order to prise back votes from the AfD she might change tack again, possibly turning more conservative, with a stricter stance on migration, EU centralisation and so on.

Secondly, the success of the AfD at the ballot box might challenge the prevailing narrative, particularly since the Dutch and French elections, that anti-EU populism is on the decline. This could have implications for markets, which arguably have become somewhat complacent in this regard. The Euro, which has been going from strength to strength in recent months, might get under pressure. Compressed peripheral risk premiums for government and corporate bonds might widen again, considering that there are more political events on the horizon, namely the Catalan independence referendum as well as elections in Austria and Italy.

This sounds remarkably like my letter from March. Was it simply that I got my timing wrong or are we both out of kilter with the markets?

The chart below shows the steady decline in unemployment across Europe:-

…take some time to look at this chart from the European Commission’s latest ‘Standard Eurobarometer’, which was released in July 2017 and is based on field surveys done two months earlier, just after the French presidential election, an event that shook the world (or, at least, the French government bond market). Suffice it to say that citizens of eurozone countries have never been so fond of the single currency.

Source: European Commission, Eurobarometer Spring 2017, Public Opinion in the European Union, BNP Paribas Asset Management

The political headwinds, which I clearly misjudged in March, are in favour of a continued convergence of Eurozone bonds. Italy and Spain offer some yield enhancement but Portugal and Greece, despite a spectacular performance year to date, still offer more value. The table below shows the yield for each market at the end of November 2009 (when European yield convergence was at its recent zenith) and the situation today. The final column shows the differential between the spreads:-

Source: Investing.com

Only Irish Gilts look overpriced on this metric. Personally I do not believe the yield differentials exhibited in 2009 were justified: but the market has been proving me wrong since long before the introduction of the Euro in 1999. Some of you may remember my 1996 article on the difference between US municipal bond yields and pre-Euro government bond yields of those nations joining the Euro. I feared for the German tax payer then – I still do now.

I expect the yield on Bunds to slowly rise as the ECB follows the lead of the Federal Reserve, but this does not mean that higher yielding European bond markets will necessarily follow suit. I continue to look for opportunities to buy Bonos versus BTPs if the approach parity but I feel I have missed the best of the Greek convergence trade for this year. Hopes that the IMF will desist in their demands for continued austerity has buoyed Greek bonds for some while. The majority of this anticipated good news is probably already in the price. If you are long Greek bonds then Irish Gilts might offer a potential hedge against the return of a Eurozone crisis, although the differential in volatility between the two markets will make this an uncomfortable trade in the meanwhile.

Back in March I expected European bond yields to rise and spreads between the periphery and the core to widen, I certainly got that wrong. Now convergence is back in fashion, at least for the smaller markets, but Europe’s political will remains fragile. The party’s in full swing, but don’t be the last to leave.

An EC white paper on the future of Europe was released at the beginning of the month

A multi-speed approach to EU integration is now considered realistic

Will a “leaders and laggards” approach to further integration work?

Will progress on integration enable the ECB to finally taper its QE?

At the Malta Summit last month German Chancellor Angela Merkel told reporters:-

We certainly learned from the history of the last years, that there will be as well a European Union with different speeds that not all will participate every time in all steps of integration.

On March 1st the European Commission released a white paper entitled the Future of Europe. This is a discussion document for debate next week, when members of the EU gather in Rome to celebrate the 60th anniversary of the signing of the Treaty of Rome.

The White Paper sets out five scenarios for the potential state of the Union by 2025:-

Scenario 1: Carrying On – The EU27 focuses on delivering its positive reform agenda in the spirit of the Commission’s New Start for Europe from 2014 and of the Bratislava Declaration agreed by all 27 Member States in 2016. By 2025 this could mean: Europeans can drive automated and connected cars but can encounter problems when crossing borders as some legal and technical obstacles persist. Europeans mostly travel across borders without having to stop for checks. Reinforced security controls mean having to arrive at airports and train stations well in advance of departure.

Scenario 2: Nothing but the Single Market – The EU27 is gradually re-centred on the single market as the 27 Member States are not able to find common ground on an increasing number of policy areas. By 2025 this could mean: Crossing borders for business or tourism becomes difficult due to regular checks. Finding a job abroad is harder and the transfer of pension rights to another country not guaranteed. Those falling ill abroad face expensive medical bills. Europeans are reluctant to use connected cars due to the absence of EU-wide rules and technical standards.

Scenario 3: Those Who Want More Do More – The EU27 proceeds as today but allows willing Member States to do more together in specific areas such as defence, internal security or social matters. One or several “coalitions of the willing” emerge. By 2025 this could mean that: 15 Member States set up a police and magistrates corps to tackle cross-border criminal activities. Security information is immediately exchanged as national databases are fully interconnected. Connected cars are used widely in 12 Member States which have agreed to harmonise their liability rules and technical standards.

Scenario 4: Doing Less More Efficiently – The EU27 focuses on delivering more and faster in selected policy areas, while doing less where it is perceived not to have an added value. Attention and limited resources are focused on selected policy areas. By 2025 this could mean A European Telecoms Authority will have the power to free up frequencies for cross-border communication services, such as the ones used by connected cars. It will also protect the rights of mobile and Internet users wherever they are in the EU.A new European Counter-terrorism Agency helps to deter and prevent serious attacks through a systematic tracking and flagging of suspects.

Scenario 5: Doing Much More Together – Member States decide to share more power, resources and decision-making across the board. Decisions are agreed faster at European level and rapidly enforced. By 2025 this could mean: Europeans who want to complain about a proposed EU funded wind turbine project in their local area cannot reach the responsible authority as they are told to contact the competent European authorities. Connected cars drive seamlessly across Europe as clear EU-wide rules exist. Drivers can rely on an EU agency to enforce the rules.

There is not much sign of a multi-speed approach in the above and yet, on 6th March the leaders of Germany, France, Italy and Spain convened in Versailles where they jointly expressed the opinion that allowing the EU to integrate at different speeds would re-establish confidence among citizens in the value of collective European action.

There are a couple of “general instruments”, contained in existing treaties, which give states some flexibility; ECFR – How The EU Can Bend Without Breaking suggests “Enhanced Cooperation” and “Permanent Structured Cooperation”(PESCO) as examples, emphasis mine:-

Enhanced cooperation was devised with the Amsterdam Treaty…in 1997, and revised in successive treaty reforms in Nice and Lisbon. Enhanced cooperation is stipulated as a procedure whereby a minimum of nine EU countries are allowed to establish advanced cooperation within the EU structures. The framework for the application of enhanced cooperation is rigid: It is only allowed as a means of last resort, not to be applied within exclusive competencies of the union. It needs to: respect the institutional framework of the EU (with a strong role for the European Commission in particular); support the aim of an ever-closer union; be open to all EU countries in principle; and not harm the single market. In this straitjacket, enhanced cooperation has so far been used in the fairly technical areas of divorce law and patents, and property regimes for international couples. Enhanced cooperation on a financial transaction tax has been in development since 2011, but the ten countries cooperating on this have struggled to come to a final agreement.

PESCO allows a core group of member states to make binding commitments to each other on security and defence, with a more resilient military and security architecture as its aim. It was originally initiated at the European Convention in 2003 to be part of the envisaged European Defence Union. At the time, this group would have consisted of France, Germany, and the United Kingdom. After disagreements on defence spending in this group and the referendum defeat for the European Constitution which meant the end of the Defence Union, a revised version of PESCO was added into the Lisbon treaty. This revised version allows for more space for the member states to decide on the binding commitments, which of them form the group, and the level of investment. However, because of its history, some member states still regard it as a top-down process which lacks clarity about how the groups and criteria are established. So far, PESCO has not been used, but it has recently been put back on the agenda by a group of EU member states.

These do not get the EU very far, but the ECFR go on to mention an additional Schengen-style approach, where international treaties of EU members can be concluded outside of the EU framework. These treaties can later be adopted by other EU members.

As part of their research the ECFR carried out more than 100 interviews with government officials and experts at universities and think-tanks across the 28 member states to discover their motivation for adopting a more flexible approach. The chart below shows the outcomes:-

Source: ECFR

Interestingly, in two countries, Denmark and Greece, officials and experts believe that more flexibility will result in greater fragmentation. Nonetheless, officials and experts in Croatia, Finland, Germany, Italy, Latvia, and Spain are in favour of embracing a more flexible approach. Benelux and France remain sceptical. Here is how the map of Europe looks to the ECFR:-

Source: ECFR

The timeline for action is likely to be gradual. President Juncker’s plans to develop the ideas contained in the white paper in his State of the Union speech in September. The first policy proposals may be drafted in time for the European Council meeting in December. It is envisaged that an agreed course of action will be rolled out in time for the European Parliament elections in June 2019.

Can Europe wait?

Two years is not that long a time in European politics but financial markets may lack such patience. Here is the Greek government debt repayment schedule prior to the European Parliament Elections:-

Source: Wall Street Journal

This five year chart shows the steady rise in total Greek government debt:-

Source: Tradingeconomics, Bank of Greece

Greek debt totalled Eur 326bln in Q4 2016, the debt to GDP ratio for 2015 was 177%. Italy’s debt to GDP was a mere 133% over the same period.

ECB dilemma

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016. The chart below shows the evolution of Eurozone long-term interest rates between October 2009 and November 2016:-

Source: ECB

In 2011 the Euro Area debt to GDP ratio was 86%, by 2015 it had reached 91%. The table below shows the highest 10yr yield since the great financial crisis for a selection of Eurozone government bonds together with their ratios of debt to GDP. It goes on to show the same ratio at the end of 2015. Only Germany is in a stronger position today than it was during the Eurozone crisis in terms of its debt as a percentage of its GDP:-

Source: Trading Economics

Since these countries bond markets hit their yield highs during the Eurozone Crisis, Greece, Italy and Spain have seen an improvement in GDP growth, but only Spain is likely to achieve sufficient growth to reduce its debt burden. If the ECB is to cease killing the proverbial fatted calf, a less profligate fiscal approach is required.

Euro Area GDP averaged slightly less than 1.8% per annum over the last two years, yet the debt to GDP ratio only declined a little over 1% from its all-time high. Further European integration sounds excellent in theory but in practice any positive impact on economic growth is unlikely to be evident for several years.

EU integration has been moving at different speeds for years, if anything, the process has been held back by attempts to move in unison. There are risks of causing fragmentation with both approaches, either within countries or between them.

Conclusions and Investment Opportunities

Another Eurozone financial crisis cannot be ruled out this year. The political uncertainty of the Netherlands is past, but France may yet surprise. Once Germany has voted in September, it will be time to focus on the endeavours of the ECB. Their asset purchase programme is scheduled to end in December.

I would expect this programme to be extended once more, if not, the stresses which nearly tore the Eurozone asunder in 2011/2012 are likely to return. The fiscal position of the Euro Area is only slightly worse than it was five years ago, but, having flirted with the lowest yields ever recorded, bond markets have considerably further to fall in percentage terms than in during the previous crisis.

Spanish 10yr Bonos represents a better prospect than Italian 10yr BTPs, but one would have to endure negative carry to set up this spread trade: look for opportunities if the spread narrows towards zero. German Bunds are always likely to act as the safe haven in a crisis and their yields have risen substantially in the past year, yet at less than ½% they are 300bp below their “safe-haven” level of April 2011.

The Euro is unlikely to rally in this environment. The chart below shows the Euro Effective Exchange Rate since 2005:-

Source: ECB

The all-time low for the Euro is 82.34 which was the level is plumbed back in October 2000. This does sound an outlandish target during the next debacle.

Euro weakness would, however, be supportive for export oriented European stocks. The weakness that stocks would initially suffer, as a result of the return of the Euro crisis, would quickly be reversed, in much the same manner that UK stocks were pummelled on the initial Brexit result only to rebound.

Last month Eurostat released German GDP data for Q 2014 at +0.7%, this was well above consensus forecasts of +0.3% and heralded a surge in the DAX stock index. For the year German growth was +1.6% this compares favourably to France which managed an anaemic +0.4% for the same period. German growth forecasts are being, feverishly, revised higher. Here is the latest data as polled by the BDA – revisions are highlighted in bold:-

The improvement in German growth has been principally due to increases in construction spending, machinery orders and, more significantly, domestic consumption, which rose 0.8% for the second successive quarter. This, rather than a resurgence in export growth, due to the decline in the Euro, appears to be the essence of the recovery. That the Euro has continued to fall, thanks to ECB QE and political uncertainty surrounding Greece, has yet to show up in the export data:-

Source: Trading Economics

German imports have also remained stable:-

Source: Trading Economics

This may seem surprising given the extent of the fall in the price of crude oil – it made new lows this week. German Natural Gas prices, which had been moderately elevated to around $10.4/btu during the autumn have fallen to $9.29/btu, a level last seen in early 2011. That the improved energy input has not shown up in the terms of trade data may be explained by the fact that crude oil and natural gas imports account for only 10% of total German imports. Nonetheless, I suspect the benevolent impact of lower energy prices is being delayed by the effects of long-term energy contracts running off. Watch for the February PPI data due out this morning (forecast -1.9% y/y).

The ZEW Institute – Indicator of Economic Sentiment – released on Tuesday, showed a fifth consecutive increase, hitting the highest level since February 2014 at 54.8 – the forecast, however, was a somewhat higher 58.2. This is an extract from their press release:-

“Economic sentiment in Germany remains at a high level. In particular, the continuing positive development of the domestic economy confirms the expectations of the experts. At the same time, limited progress is being made with regard to solving the Ukraine conflict and the sovereign debt crisis in Greece. This has a dampening effect on sentiment,” says ZEW President Professor Clemens Fuest. The assessment of the current situation in Germany has improved notably. Increasing by 9.6 points, the index now stands at 55.1 points.

The good news is not entirely unalloyed (pardon the pun) IG Metall – the German metal workers union which sets the benchmark for other union negotiations – achieved a +3.4% wage increase for their 800,000 members in Baden Württemberg, starting next month. Meanwhile, German CPI came in at 0.09% in February after falling -0.4% in January. This real-wage increase is an indication of the tightness of the broader labour market. Nationally wages are rising at a more modest 1.3%, this is, however, the highest in 20 years. German unemployment fell to 4.8% in January, the lowest in 33years, despite the introduction of a minimum wage of Eur8.50/hour, for the first time, on 1st January.

One of my other concerns for Germany is the declining trend of productivity growth. Whilst employment has been growing, the pace of productivity growth has not. This 2013 paper from Allianz – Low Productivity Growth in Germany examines the issue in detail, here is the abstract:-

Since the labor market reforms implemented in the first half of the last decade, Germany’s labor market has been on a marked upward trend. In 2012, there were 2.6 million (+6.8%) more people in work than in 2005 and the volume of labor was up by 2.4 million hours (+4.3%) on 2005. But the focus on this economic success, which has also earned Germany a great deal of recognition on the international stage, makes it easy to overlook the fact that productivity growth in the German economy has continued to slacken. Whereas the increase in labor productivity per person in work was still averaging 1.0% a year between 1995 and 2005, the average annual increase in the period between 2005 and 2012 was only 0.5%. The slowdown in the pace of labor productivity growth, measured per hour worked, is even more pronounced. The average growth rate of 1.6% between 1995 and 2005 had slipped back to 0.9% between 2005 and 2012.

Allianz go on to make an important observation about the importance of capital investment:-

…the capital factor is now making much less of a contribution to economic growth in Germany than in the past, thus also putting a damper on labor productivity growth.

… Since the bulk of the labor market reforms came into force – in 2005 – the German economy has been growing at an average rate of 1.5% a year. Based on the growth accounting process, the capital stock delivered a growth contribution of 0.4 percentage points, with the volume of labor also contributing 0.4 percentage points. This means that total factor productivity contribute 0.7 percentage points to growth. So if the volume of labor and capital stock were to stagnate, Germany could only expect to achieve economic growth to the tune of 0.7% a year.

…Although gross domestic product also grew by 1.5% on average during that period, labor productivity growth came in at 2.0%, more than twice as high as the growth rate for the 2005 – 2012 period. Between 1992 and 2001, the contribution to growth made by the capital stock, namely 0.9 percentage points, was much greater than that made in the period from 2005 to 2012; by contrast, the growth contribution delivered by the volume of labor was actually negative in the former period, at -0.4 percentage points, and 0.8 percentage points lower than between 2005 and 2012. This could allow us to draw the conclusion that the labor market reforms boosted economic growth by 0.8 percentage points a year. Although there is no doubt that this conclusion is something of a simplification, the sheer extent of the difference supports the theory that the labor market reforms had a marked positive impact on growth. In the period between 1992 and 2001, total factor productivity contributed 1.0 percentage points to growth, 0.3 percentage points more than between 2005 and 2012. This tends to suggest that the growth contribution delivered by technical progress is slightly on the wane.

…The finding that the weaker productivity growth in Germany is due, to a considerable extent, to the insufficient expansion of the capital stock and, consequently, to excessive restraint in terms of investment activity, suggests that there is a widespread cause, and one that is not specific to Germany, that is putting a stranglehold on the German productivity trend.

…The hope remains, however, that especially Germany – a country that has managed to get to grips with the crisis fairly well in an international comparison – will be able to return to more dynamic investment activity as soon as possible.

The issue of under-investment is not unique to Germany and is, I believe, a by-product of quantitative easing. Interest rates are at negative real levels in a number of countries. This encourages equity investment but, simultaneously, discourages companies from investing for fear that demand for their products will decline once interest rates normalise. Instead, corporates increase dividends and buy back their own stock. European dividends grew 12.3% in 2014 although German dividend growth slowed – perhaps another sign of a return to capital investment.

German Bunds

Bunds made new highs again last week. The 10 year yield reached 19 bp. Currently, Bunds up to seven years to maturity are trading at negative yields. These were the prices on Wednesday after then 10 year Bund auction:-

Maturity

Yield

1-Year

-0.18

2-Year

-0.225

3-Year

-0.202

4-Year

-0.173

5-Year

-0.099

6-Year

-0.065

7-Year

-0.025

8-Year

0.053

9-Year

0.127

10Y

0.212

15-Year

0.38

20-Year

0.519

30-Year

0.626

Source: Investing.com

Wednesday’s 10 year auction came in at 0.25% with a cover ratio of 2.4 times, demand is still strong. The five year Bobl auction, held on 25th February, came with a negative 0.08% yield for the first time. Negative yields are becoming common-place but their implications are not clearly understood as this article from Bruegal – The below-zero lower bound explains – the emphasis is mine):-

The negative yields observed on some government and corporate bonds, as well as the recent move into further negative territory of monetary policy rates, are shaking our understanding of the ZLB constraint.

…Matthew Yglesias writes…Interest rates on a range of debt — mostly government bonds from countries like Denmark, Switzerland, and Germany but also corporate bonds from Nestlé and, briefly, Shell — have gone negative.

…Evan Soltas writes…economists had believed that it was effectively impossible for nominal interest rates to fall below zero. Hence the idea of the “zero lower bound.” Well, so much for that theory. Interest rates are going negative all around the world. And not by small amounts, either. $1.9 trillion dollars of European debt now carries negative nominal yields,

…Gavyn Davies writes…the Swiss and Danish central banks are testing where the effective lower bound on interest rates really lies. Denmark and Switzerland are clearly both special cases, because they have been subject to enormous upward pressure on their exchange rates. However, if they prove that central banks can force short term interest rates deep into negative territory, this would challenge the almost universal belief among economists that interest rates are subject to a ZLB.

…JP Koning writes that there are a number of carrying costs on cash holdings, including storage fees, insurance, handling, and transportation costs. This means that a central bank can safely reduce interest rates a few dozen basis points below zero before flight into cash begins. The lower bound isn’t a zero bound, but a -0.5% bound (or thereabouts).

…Evan Soltas writes that if people aren’t converting deposits to currency, one explanation is that it’s just expensive to carry or to store any significant amount of it…How much is that convenience worth? It seems like a hard question, but we have a decent proxy for that: credit card fees, counting both those to merchants and to cardholders…The data here suggest a conservative estimate is 2 percent annually.

…Barclays writes…Coincidentally, the ECB has calculated that the social welfare value of transactions is 2.3%.

…Brad Delong writes…In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it.

Whilst none of these authors definitively tell us how negative is too negative, it is clear that negative rates may have substantially further to go. The only real deterrent is the negative cost of carry, which is likely to make price fluctuations more volatile.

German Stocks

Traditionally Germany was the preserve of the bond investor. Stocks have become increasingly popular with younger investors and those who need yield. Corporate bonds used to be an alternative but even these issues are heading towards a zero yield. I have argued for many years that a well-run company, whilst limited by liability, may be less likely to default or reschedule their debt than a profligate government. Even today, corporates offer a higher yield – the only major concern for an investor is the liquidity of the secondary market.

Nonetheless, with corporate yields fast converging on government bonds, stocks become the “least worst” liquid investment, since they should be supported at the zero-bound – I assume companies will not start charging investors to hold their shares. Putting it in finance terms; whereas we have been inclined to think of stocks as “growth” perpetuities, at the “less-than-zero-bound”, even a “non-growth” perpetuity looks good when compared to the negative yield on dated debt. We certainly live in interesting, or perhaps I should say “uninteresting” times.

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years.

…while German institutions and policymakers are as responsible as those in peripheral Europe for the debt crisis, in fact it was German and peripheral European workers who ultimately bear the cost of the distortions, and it will be German households who will pay to clean up German banks as, one after another, the debts of peripheral European countries are explicitly or implicitly written down.

…In many countries in Europe there is tremendous uncertainty about how debt is going to be resolved. This uncertainty has an economic cost, and the cost only grows over time. But because most policymakers stubbornly refuse to consider what seems to have become obvious to most Europeans, there is a very good chance that Europe is going to repeat the history of most debt crises.

…For now I would argue that the biggest constraint to the EU’s survival is debt. Economists are notoriously inept at understanding how balance sheets function in a dynamic system, and it is precisely for this reason that we haven’t put the resolution of the European debt crisis at the center of the debate. But Europe will not grow, the reforms will not “work”, and unemployment will not drop until the costs of the excessive debt burdens are addressed.

If Pettis is even half-right, the restructuring of non-performing EZ debt will be a dislocating process during which EZ government bond yields will vacillate wildly. If the German government ends up footing the bill for the lion’s share of Greek debt, rather than letting its banking system default, then stocks might become an accidental “safe-haven” but I think it more likely that rising Bund yields will precipitate a decline in German stocks.

Here is how the DAX Index has reacted to the heady cocktail of ECB QE, a falling Euro and a deferral of the Greek dilemma:-

Source: Barchart.com

The DAX has more than doubled since the dark days of 2011 when the ECB saved the day with rhetoric rather than real accommodation. From a technical perspective we might have another 1,500 points to climb even from these ethereal heights – I am taking the double top of 2000 and 2007 together with the 2003 low and extrapolating a similar width of channel to the upside – around 13,500. The speed of the rally is cause for concern, however, since earnings have yet to catch up with expectations, but, as I pointed out earlier, there are non-standard reasons why the market may be inhaling ether. The current PE Ratio is 21.5 times and the recent rally has made the market look expensive relative to forward earning. At 13,500 the PE will be close to 24.5 times. This chart book from Dr Ed Yardeni makes an excellent case for caution. This is a subscriber service if you wish to sign up for a free trial.

The domestic nature of the economic resurgence is exemplified most clearly by the chart below which shows the five year performance of the DAX Index versus the mid-cap MDAX Index, I believe it is time for the large cap stocks to benefit from the external windfalls of a weaker Euro and lower energy prices:-

Source: Finanzen.net

Real Estate

In Germany, Real Estate investment is different. Government policy has been to keep housing affordable and supply is therefore plentiful. This article from Inside Housing – German Lessons elaborates:-

Do you fancy a one-bed apartment in Berlin for £35,000 or a four- bed detached house in the Rhineland for £51,000?

In many parts of Germany house prices are a fraction of their UK equivalents – in fact, German house prices have decreased in real terms by 10 percent over the past thirty years, whereas UK house prices have increased by a staggering 233 percent in real terms over the same period. Yet German salaries are equal to or higher than ours. As a consequence Germans have more cash to spend on consumer goods and a higher standard of living, and they save twice as much as us, which means more capital for industry and commerce. Is it any surprise that the German economy is consistently out-performing ours?

There are a number of reasons for the disparity between the German and UK housing markets. Firstly, German home ownership is just over 40 percent compared to our 65 percent (there are stark regional variations – in Berlin 90 percent of all homes are privately rented) and the Germans do not worship ownership in the way we do. Not only is it more difficult to get mortgage finance (20 percent deposits are a typical requirement) but the private rented sector offers high quality, secure, affordable and plentiful accommodation so there are fewer incentives to buy. You can rent an 85 square metre property for less than £500 per month in Berlin or for around £360 per month in Leipzig. There is also tight rent control and unlimited contracts are common, so that tenants, if they give notice, can stay put for the long-term. Deposits must be repaid with interest on moving out.

In addition, Germany’s tax regime is not very favourable for property owners. There is a property transfer tax and an annual land tax. But the German housebuilding industry is also more diverse than ours with more prefabraction and more self-builders. The German constitution includes an explicit “right-to-build’’ clause, so that owners can build on their property or land without permission so long as it conforms with local codes.

But the biggest advantage of the German system is that they actively encourage new housing supply and release about twice as much land for housing as we do. German local authorities receive grants based on an accurate assessment of residents, so there is an incentive to develop new homes. The Cologne Institute for Economic Research calculated that in 2010 there were 50 hectares of new housing development land per 100,000 population in Germany but only 15 hectares in the UK. That means the Germans are building three times as many new homes as us pro-rata even though our population growth is greater than theirs. This means that German housing supply is elastic and can respond quickly to rising demand…

German rental protection laws – for the renter – are stronger than in other countries – this encourages renting rather than buying. From an investment perspective this makes owning German Real Estate a much more “bond like” proposition. With wages finally rising and economic prospects brightening, Real Estate is a viable alternative to fixed income. The table below was last updated in May 2014, at that time 10 yr Bunds were yielding around 1.5%:-

For comparison, commercial office space in these three locations also offers a viable yield: –

Office Location

Yield

2013

2012

2011

Berlin

4.7

4.8

4.95

Frankfurt

4.65

4.75

4.9

Munich

4.4

4.6

4.75

Source: BNP Paribas

I believe longer term investors are fairly compensated for the relative illiquidity of German Real Estate.

The Euro

For the international investor, buying Euro denominated assets exposes one to the risk of a continued decline in the value of the currency. The Euro Effective Exchange Rate is still near the middle of its long-term range, as the chart below illustrates, though since this chart ends in Q4 2014 the Euro has weakened to around 90:-

Source: ECB

Investors must expect further Euro weakness whilst markets obsess about the departure of Greece from the EZ, however, a “Grexit” or a resolution (aka restructuring/forgiveness) of Greek debt will allow the markets to clear.

Conclusion and Investment Opportunities

German Bunds continue to be the safe-haven asset of choice for the EZ, however, for the longer term investor they offer negligible or negative returns. German Real Estate, both residential and commercial, looks attractive from a yield perspective, but take care to factor in the useful life of buildings, since capital gains are unlikely.

This leaves German equities. A secular shift from bond to equity investment has been occurring due to the low level of interest rates, this has, to some extent, countered the demographic forces of an aging German population. Nonetheless, on a P/E ratio of 21.5 times, the DAX Index is becoming expensive – the S&P 500 Index is trading around 20 times.

At the current level I feel it is late to “arrive at the party” but on a correction to test the break-out around 10,000 the DAX looks attractive, I expect upward revisions to earnings forecasts to reflect the weakness of the Euro and the lower price of energy.